Michigan

Opinion: Appearances may be deceiving for community banks

When it comes to community banking in West Michigan, things are not what they appear to be — at least, not yet.

Nationally, economic indicators demonstrate things are slowly getting somewhat better. The economy grew 2.5 percent during the first nine months of this year, a modest amount of new jobs are being created and residential real estate prices are, for the most part, stabilizing.

But we are not seeing this cross over to community banks.

What growth we have seen is limited or inconsistent. Loan demand is limited. Perhaps it’s not that the economy is really getting better, but that we are hearing more good-than-bad these days.

As we wrap up 2011, it is good to keep an eye on:• Provisions for loan losses. One of the best ways to gauge a bank’s current health is by reviewing its loan loss provisions. Community banks are sending mixed signals. On the one hand, a recent article in American Banker noted that 40 percent of all community banks increased their loan loss provisions in the third quarter of 2011 over the second quarter, meaning that a significant number think they have some trouble ahead in their loan portfolios.

Locally, though, we have banks that are steadily reducing their loan loss provisions. For example, Mercantile Bank set aside $6.8 million in the fourth quarter of 2010, which is now down to $1.1 million in the just-completed third quarter. This indicates its management believes its portfolio is improving.

• More provisions for loan losses. Historically, banks have built their reserves in good times and let them out in bad. But a decade ago, the U.S. Securities and Exchange Commission told banks this was bad accounting, and they needed to stop building cookie jars. So banks followed SEC direction and took a very public beating when the economy bottomed out.

We are starting to see banks go back to the old-school accounting and again build up their loan loss reserves.

• Less growth. With regulatory capital pressures, banks are trying not to grow assets. This need to control balance sheet size will not encourage banks to compete for deposits, so don’t expect to get more interest on your personal bank accounts any time soon.

• Thin margins. As long as the Fed holds down interest rates, the banks’ interest margins will be thin. A bank’s interest margin is a commercial company’s equivalent of gross profit. Because margins are thin, community banks have had to do an excellent job of holding down costs. As the economy began to wobble in 2008, banks started to pay more attention to their expenses and began cutting back.

Some local banks have gone so far as to have everyone vacuum their own offices in order to save money. This spirit of frugality continues as banks look to focus spending on the essentials to further hasten their recovery. Margins are not expected to get better any time soon, so expect bank management to look for low-hanging fruit, such as payroll.

• New footnote for private banks. Finally, starting in 2011, privately held banks will join their publicly traded cousins by adding a new footnote detailing the condition of their loan portfolios. The Financial Accounting Standards Board mandated this disclosure — including detailed information on loan losses, classified loans, impaired loans and troubled debt restructurings — for publicly traded banks in 2010, giving some extra time for private banks to catch up. Expect to see four or five additional pages of new disclosure in financial statements this year. The detail in the footnote that only a bean counter could love.

Jon Chism is a partner in the Grand Rapids office of Plante Moran in Grand Rapids who concentrates his practice in banking.